The use of online planning tools with stochastic models has exposed the wide variety of income and investment options individuals can take in retirement. When applied to the rules of thumb commonly used in retirement, these tools are starting to show that many of our hunches and biases for how we should save, spend and invest in retirement are not reliable.
David Schneider, head of research at UniSuper, plus Paul Newfield and Jeffrey Chee, both senior actuaries at Towers Watson (pictured), have spent the first six months of the year building what they believe to be the most advanced online planning tool. Dubbed the complex adaptive retirement strategy (CARS), it factors in 1,000 stochastic demographic simulations, over 1,000 potential retirement portfolios and 44 asset classes multiplied across 2,000 investment simulations over 50 years.
In an exclusive interview with Investment Magazine, the three creators of CARS discussed five retirement fallacies that their model has fully exposed.
Simple financial advice may produce something close to an optimal asset allocation
In challenging this notion, Jeffrey Chee cites the work of John DeRavin, vice president of risk and actuarial planning at Swiss Re, who has written papers questioning the efficacy of financial advice. Part of DeRavin conclusions are that financial plans for retirement tend to be partially decided on the biases of the client, rather than optimal asset allocations. This is due to the dynamics of the client paying for advice, rather than being instructed on how to act. It is also limited by each client’s ability to understand all the investment and investment strategies recommended to them.
Chee says: “Either the questions are too difficult for lay persons to answer or they are structured in such a way that the answer coming back to the individual is essentially what the individual wants to do.”
The trend for advisers to place greater reliance on stochastic retirement software such as CARS would appear to offer a greater science to the business of optimal asset allocations in retirement. Chee says: “This could augment the toolkit financial planners use to help them have metrics they can communicate to their clients. And to also improve the consistency of advice provided to different individuals in the same situation.”
$1 million dollars is enough for a comfortable retirement
The only thing certain about a $1 million balance at the point of retirement is that it is better than a smaller figure. The CARS modeller shows that across billions of potential health, wealth, spending and investment market scenarios an individual might need as little as $300,000 or as much as $2 million to fund their retirement needs. The lesson is that greater thought needs to be put into working out spending and investment styles in retirement. The team who have built CARS believe there is also a need for quarterly check-ups on how a retiree’s balance is invested and consumed as investment markets and the health and the spending needs of the retiree change.
Such findings also bring into question the worth of the 4 per cent rule, a common gauge on what is the safest rate of drawdown from savings to avoid depleting them too soon.
Retirees should aspire and plan for a specific rate of income in retirement
While it is generally accepted that one’s spending needs in retirement are likely to be high at first, before dropping and then rising as one’s health worsens, most models such as the ASFA Retirement Standard, assume, for ease of understanding, a single target level of income for retirement income.
Paul Newfield says: “It is fallacy that people should aim for a steady amount of consumption. The reason why that has continued to persist to this day is partly because there has not been the computational or actuarial rigor applied at an individual level. And secondly for product sellers it is easier to model it mathematically.”
He says that a model such as CARS will allow individuals to disaggregate between minimum income for basic needs and discretionary income. Schneider adds: “No one sticks to the same spending plan. They know instinctively if their wealth is reducing and will adjust their spending accordingly.”
As you get older you should take less investment risk
A low risk investment strategy instinctively appeals to those who are no longer earning a salary and are keen to hold onto what they have and not to put it at risk of market crashes. For some this strategy maybe wise, but for others it will bring the prospect of the ruin year closer.
Using 50 years of sophisticated prospective models for investment markets, CARS shows how low growth strategies and high drawdown rates can lead to a significantly higher risk of retirees outliving their assets. Schneider says that such a prospect may well be scarier than equity volatility, which could lessen the chance of this happening. The main barrier is the risk biases of retirees, but Schneider believes the CARS model can also be useful as an educational role. He paints an analogy of Columbus sailing for the new world. “You have tides, currents and sometimes big waves (this represents investment markets), but the real risk is how much of your food supply should you consume (akin to your retirement savings), given you do not know how many days you will be at sea?”
He says that if people are shown the range of volatility that is acceptable for equity markets, then they can be comforted by this. Additionally, he suggests a strategy could be opportunistic, by taking winnings off the table after a market rally.
One should plan one’s retirement based on the average age of death
One of the few ways many of us attempt to gain some certainty in retirement is by checking the average longevity of our age cohort. This can be used to project how far savings should last, but such averages can be misleading and do not stand up to mathematical scrutiny.
Chee gives the example that when the government states the average 65 year old will live to age 85 this ignores the median life expectancy, which is higher. The average life expectancy is skewed by early deaths soon after age 65. This means, as Chee states, that there is more than a 50 per cent chance that you will live longer than the average mortality quoted for your cohort. “More than 50 per cent of people live beyond the average,” he says. “So planning to extinguish your wealth by the time you reach your life expectancy is not a good idea.”